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HCL Infosys: Falling realisations

HCL Infosystems has closed fiscal 02 with a 9% growth in revenues. However, the company’s net profits have declined by a steep 21% for the second consecutive year. The drop in bottomline is due to a sharp decline in operating margins. The fall in operating margins began in FY99 and has continued since. However, the fall in FY02 was the steepest as margins fell from 7.7% in FY01 to 4.7% in FY02.

The fall in margins was due to the fact that the company earns a significant portion of revenues from selling hardware (83% in FY01). This includes computer systems, accessories, peripherals, mobile phones, EPABX systems and office automation products. HCL Infosystems has manufacturing facilities for computers; while for other products the company is channel partner.

(Rs m)

4QFY01*

4QFY02

Change

FY01

FY02

Change

Sales

2,509

4,026

60.4%

11,623

12,613

8.5%

Other Income

15

5

-67.3%

61

87

42.1%

Expenditure

2,334

3,890

66.7%

10,784

12,022

11.5%

Operating Profit (EBDIT)

175

137

-22.2%

839

591

-29.5%

Operating Profit Margin (%)

7.0%

3.4%

7.2%

4.7%

Interest

0

7

3423.8%

19

37

95.3%

Depreciation

32

37

14.9%

122

127

3.5%

Profit before Tax

158

97

-38.7%

759

515

-32.2%

Tax

15

9

-40.7%

69

53

-22.9%

Provision and contingencies loss/(income)

11

-

106

-

Profit after Tax/(Loss)

132

88

-33.5%

584

461

-21.0%

Net profit margin (%)

5.3%

2.2%

5.0%

3.7%

Diluted number of shares

31.9

31.9

31.9

31.9

Diluted Earnings per share*

16.6

11.0

18.3

19.3

P/E (x)

9.3

5.3

*(annualised)

Numbers not given by the company and have therefore, been arrived at by deducting first three quarter financials from full year numbers.

With increased competition from MNC brands like Dell, IBM and Compaq, Indian brands in the PC industry find the going getting tougher. The bleak situation has been further aggravated by the fact that PC sales were significantly lower than expected in FY02, due to a slowdown in the Indian economy. Both the factors combined have resulted into a price war among the PC manufacturers and therefore, have caused realisations to plummet.

While HCL Infosystems has managed to cut corners to cushion the impact of falling realisations by cutting staff and SGA (selling, general and administrative) expenses to some extent, a 16% growth in cost of sales (mainly material and manufacturing costs) dented the operating margins. The impact is even more evident in the 4QFY02 numbers. While revenues have jumped by 60% on a YoY basis, net profits are down by 37%.

Another reason for the fall in operating margins is the steep fall in share of revenues from the company’s services business from 16% in FY01 to 6% in FY02. However, the decline in the numbers could also be due to the classification of revenues. Earlier product related services could have been included in services, which has been grouped with products in FY02.

Revenues (Rs m)

FY99

FY00

FY01

FY02

Products and related services

7,847

9,575

9,689

11,899

Services

1,814

1,674

1,935

714

Total

9,660

11,249

11,624

12,613

% Contribution

Products and related services

81.2%

85.1%

83.4%

94.3%

Services

18.8%

14.9%

16.6%

5.7%

Total

100.0%

100.0%

100.0%

100.0%

However, the company’s operating margins from the services business is rather disappointing. The PBIT (profit before interest and taxes) margins at 18% for the software services business are way below industry averages.

While the numbers undoubtedly are very disappointing, this has more to do with the macro environment than the company’s own doing. HCL Infosys has taken a number of steps to counter the difficult environment. It is one the first hardware companies to reach out to newer market segments such as smaller towns that have traditionally had to rely on assembled machines.

Another positive is the fact that HCL Infosystems is one of the few players that can provide end to end solutions for setting up call centres, an industry that is expected to grow swiftly. The company could see strong growth in revenues from this segment. However, this contribution is likely to be very small. Also, the with the VoIP (voice over internet protocol) market growing rapidly in India networking services providers like HCL Infinet, HCL’s Infosystems subsidiary, are likely to see good times ahead.

At the current market price of Rs 102, the stock trades at a P/E multiple of 5x its FY02 earnings. HCL Technologies is one of the very few companies that manufacture hardware, provide software services and also has presence in the Internet infrastructure segment. This is a very strong investment argument in favour of the company. However, the macro environment for the hardware industry is likely to remain tough going forward. With the monsoons being lower than normal, whatever little rebound that has been seen in the industry in unlikely to sustain. Further the competition from foreign players is likely to intensify. Thus, the stock price is likely to remain range bound for quite sometime in the future.

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